Guide to Precious Metals: Gold

NEW YORK ( TheStreet) -- With the introduction of exchange traded funds, investors have been given the opportunity to play not only stocks and bonds, but also precious metals. As the number of retail investors boasting gold, silver and other shiny metals within their portfolios has blossomed, this slice of the market has evolved into a whole new asset class.

Many investors are familiar with veteran metals funds such as SPDR Gold Shares ( GLD) and iShares Silver Trust ( SLV). However, over the years ETF providers have introduced new products which provide investors access to not only gold and silver, but also platinum and palladium. ETFs and ETNs today can expose investors to the physical commodity, futures contracts and individual gold miners. Additionally, as the ETF industry has expanded, investors have been given the opportunity to take leveraged bets on the performance of popular precious metals.

Over the next two days I will examine the various precious metal exchange traded products and compare their relative strengths.

Gold

Physically-Backed. Today, ETF investors can choose among three funds to play physical gold. The iShares COMEX Gold Trust ( IAU); GLD and ETFS Physical Swiss Gold Shares ( SGOL) all seek to meet the same goal: track the price of gold bullion. However, beyond this strategy, there are a number of important differences between the three options to consider.

Launched at the end of 2004, GLD holds the title of being first mover in the physically backed gold ETF arena. IAU, the second fund to make an appearance was launched slightly over two months later. Together, these two funds dominated the niche until the close of 2009, when SGOL was launched.

With over 16 million shares changing hands each day, GLD is the most liquid of the three options and is therefore best suited for active traders. With all three handily surpassing 100,000 shares traded per day, buy and hold investors would do well holding any of the three.

SGOL, launched by ETF Securities, has attempted to draw in bargain-hunting investors by differentiating itself. The fund cut its expense ratio by a single basis point, charging investors 0.39% rather than the typical 0.40%. Also, to address investors' concerns about storage, SGOL keeps its gold in Switzerland. These differences have helped SGOL amass a respectable $400 million in assets.

The physically backed ETFs are taxed as collectibles, with a 28% long-term capital gains rate.

Futures Backed. PowerShares has launched its own product designed to draw in gold bulls, the PowerShares DB Gold Fund ( DGL). Unlike GLD, IAU and SGOL, DGL follows the price of gold by tracking a basket of futures contracts.

The fund follows a Deutsche Bank optimum-yield index to select contracts for the ETF. This strategy attempts to minimize the effects a negative contract roll can have on the fund while maximizing the positive gains seen from backwardation.

Currently, futures-based precious metals ETFs like DGL have fallen under the scrutiny of the Commodities Futures Trading Commission. The regulatory body is concerned that if a single futures-backed commodity fund were to grow too large, it could manipulate or distort the market. In an effort to stop an event like this from occurring, the CFTC has recently been considering tightening position limits.

With a three month average volume of less than 50,000, this fund is less liquid than the physically backed options. Players looking to move quickly in and out of positions should use caution.

They are taxed as futures, with a 60% long-term capital gains rate and a 40% short-term capital gains rate. Each investor in these funds is responsible for paying annual taxes and receives a Schedule K-1 form every year reporting his or her share of the fund's income.

Leveraged. There exists a number of exchange traded funds and notes that allow investors to take magnified bullish or bearish bets on the future price of gold. First are the ETFs: ProShares Ultra Gold ETF ( UGL) and ProShares UltraShort Gold ETF ( GLL). These are taxed the same as the futures ETFs and deliver 2X the daily movement in the price of gold.

PowerShares offers leveraged gold ETNs tracking Deutsche Bank optimum yield indexes. There are two big differences from the ProShares. First, they come with the addition of issuer credit risk (in this case Deutsche Bank), since these are structured as debt, but that also means they are taxed at the same as single stocks, with short- or long-term capital gains dependent on how long the investor holds the fund. Second, the PowerShares ETNs reset monthly, not daily.

The two choices here are: PowerShares DB Gold Double Long ETN ( DGP) and PowerShares DB Gold Double Short ETN ( DZZ). Since the inception of the ProShares funds, these DGP and DZZ have slightly outperformed their counterparts.

Volume is ample in all four leveraged funds. In the past year, the leveraged long funds have delivered double the return of gold. The leveraged short funds, meanwhile, have delivered less than 2X the inverse, due to compounding.

As I've explained in the past, leveraged ETFs and ETNs should not be held as long term positions and are appropriate only for advanced investors. Additionally, like DGL, these products are currently under the scrutiny of regulatory bodies due to their use of futures and derivatives to meet their underlying investing goals.

Short. PowerShares also offers a short ETN, PowerShares DB Gold Short ETN ( DGZ) , which does not use leverage. As the chart on the next page shows, however, it underperformed like the leveraged short funds and failed to deliver the full inverse return.

In general, investors should stick with the physically backed funds, which do not carry the credit risk of ETNs or the risk of futures contracts and potential disruption due to new CFTC regulation of those contracts. That goes ever more so for those in tax-sheltered accounts, who will derive no benefit from an ETN.

For the leveraged funds, investors opting for a slightly longer holding period may find the PowerShares funds better, but outside of a tax-sheltered account, the main difference is in how the funds are taxed.

At the time of publication, Dion Money Management owned IAU.

-- Written by Don Dion in Williamstown, Mass.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.